The record of international transactions

The balance of payments is a set of accounts recording transactions between the residents of one country and residents of the rest of the world over a stated period, normally one year. Residency depends on where a person’s centre of economic activity lies, rather than simply on citizenship.

A credit item is an international transaction that brings a payment into the country. Export revenue is one example, as are investment entering from abroad and foreign borrowing. A debit item sends a payment out of the country, such as spending on imports or purchasing foreign assets.

Don’t treat a credit as “good” or a debit as “bad”. The labels only show the direction of the recorded payment. Imported machinery, for instance, is a debit even though it may increase productive capacity.

Surpluses, deficits and calculations

An account surplus is a positive account balance that occurs when credits exceed debits. An account deficit is a negative account balance that occurs when debits exceed credits.

For any account:

If credits are 180 billion and debits are 225 billion, then $B=180-225=-45$ billion. So, the account has a deficit of 45 billion. Keep the sign in your working; this helps prevent a deficit from being reported accidentally as a positive balance.

The current account

The current account records trade in goods and services, primary income and current transfers within the balance of payments.

It has four components:

• The balance of trade in goods equals the value of exported physical products minus the value of imported physical products. This includes cars, food and machinery.
• The balance of trade in services equals the value of exported services minus the value of imported services. Examples include tourism, transport, insurance and consultancy.
• Income measures the net flow of earnings from labour and the ownership of productive or financial assets. It covers wages, profits, interest and dividends received from abroad minus those paid abroad.
• A current transfer is a one-way current payment where no good, service or asset is received directly in return. Examples include personal remittances and some international grants.

The current account can be calculated as follows:

Suppose goods exports are 120 billion and goods imports are 150 billion. Service exports are 55 billion, service imports are 40 billion, net income is minus 8 billion and net current transfers are minus 7 billion. Then:

The current account therefore has a deficit of 30 billion.

The capital account

The capital account records capital transfers and transactions in non-produced, non-financial assets within the balance of payments. It is usually much smaller than the current and financial accounts.

A capital transfer is a one-way transfer linked to the ownership of an asset or the cancellation of a liability, such as debt forgiveness. A non-produced, non-financial asset wasn’t created through production and isn’t a financial claim. Examples include certain rights to natural resources, leases or transferable contractual rights.

The financial account

The financial account records cross-border changes in the ownership of financial assets and liabilities within the balance of payments.

Its main components are:

• Foreign direct investment is cross-border investment that gives an investor a lasting interest and significant influence over an enterprise. Constructing a factory or acquiring a controlling stake are examples.
• Portfolio investment is cross-border investment in financial securities that doesn’t provide significant managerial control, such as purchases of shares or government bonds.
• Reserve assets are external financial assets controlled by the monetary authority and available for international payments or foreign-exchange intervention. These may include foreign currencies and foreign government securities.
• Official borrowing is borrowing by a government or monetary authority from foreign lenders or international institutions.

Each component can create either a credit or a debit. If a foreign company buys a domestic business, this produces an inward direct-investment flow and a credit. If a domestic company buys a business abroad, it produces an outward flow and a debit.

Reserve assets need particular care. When a central bank sells foreign reserves and brings the proceeds into the domestic economy, the transaction is recorded as a credit, while its stock of reserves falls. When the central bank buys additional foreign reserves, the transaction is a debit and its reserve holdings rise.

The classification of the accounts, along with typical credit and debit transactions, is shown below.

Balance-of-payments components with typical credit and debit entries.

Why the overall balance is zero

Each international transaction creates matching entries. When a resident imports a product, the import enters the current account as a debit. The foreign seller’s payment then creates a corresponding financial flow. Across the full set of accounts, credits therefore match debits.

The accounting identity is:

This identity doesn’t say that each individual account equals zero. Instead, a deficit in one account must be matched by a surplus across the others. The capital account is generally small, so a current account deficit is usually matched mainly by a financial account surplus.

Suppose the current account is minus 30 billion and the capital account is plus 2 billion:

The financial account must therefore be plus 28 billion.

How a deficit is financed

When a country runs a current account deficit, it spends more through current international transactions than it receives. The counterpart may be inward direct investment, portfolio-investment inflows or official borrowing. If private inflows aren’t enough, the monetary authority may sell reserve assets. This sale is recorded as a financial-account credit.

The balancing identity doesn’t make the economic issue disappear; it shows how the deficit has been financed. Productive long-term investment may provide more sustainable financing than repeated short-term borrowing or the depletion of reserve assets.

Current-account transactions in the foreign-exchange market

Export revenue counts as a credit. To pay for domestic goods and services, foreign buyers normally demand the exporter’s currency. Demand for that currency rises. Import expenditure is a debit: domestic buyers supply their own currency to obtain foreign currency.

A current account deficit can put downward pressure on the exchange rate. Large import payments add to the supply of the domestic currency; weak export earnings may leave demand for it relatively low. In a floating system, this may lead to depreciation. A current account surplus usually creates the opposite pressure. Strong export receipts raise demand relative to supply and may cause appreciation.

The standard diagram traces one route from a larger current account deficit to depreciation. Higher import expenditure shifts the supply of the domestic currency to the right, so its equilibrium exchange rate falls.

Label the diagram carefully. The vertical axis should show the exchange rate in units of foreign currency per unit of domestic currency. Using this quotation, movement down the axis represents a depreciation of the domestic currency. Reverse the quotation and the interpretation reverses too.

Two-way causation

Causation also works in the other direction: the exchange rate affects the current account. Depreciation reduces the foreign-currency price of exports while raising the domestic-currency price of imports. The current account may improve if quantities respond sufficiently, but this isn’t automatic. The outcome depends on contracts and production capacity, as well as price elasticities.

An appreciation tends to make exports more expensive for foreign buyers while making imports cheaper for domestic buyers. That may weaken the current account. Once again, the scale and timing depend on the responses of buyers and firms.

Financial inflows and outflows

A financial-account credit creates demand for the domestic currency. For example, when a foreign investor buys a domestic company, factory, share or bond, they exchange foreign currency for domestic currency. Other things equal, inward foreign direct investment, inward portfolio investment and foreign lending put upward pressure on the exchange rate.

A financial-account debit does the opposite: it increases the supply of domestic currency. Residents buying foreign businesses, shares or bonds must sell domestic currency to get the foreign currency they need. Large outward investment flows therefore put downward pressure on the exchange rate.

A financial account surplus is linked to net demand for domestic financial assets, so it may support appreciation. By contrast, a financial account deficit involves the net acquisition of foreign assets and may contribute to depreciation.

Interest rates, expectations and feedback

Financial flows can respond quickly to differences in interest rates, shifts in expectations and changes in risk. Higher domestic interest rates may attract portfolio investment if investors believe the return makes up for inflation, default risk and possible exchange-rate losses. The extra demand for the currency can lead to appreciation.

The effect also runs the other way, as the exchange rate influences financial decisions. If investors expect future depreciation, they may avoid domestic assets or withdraw funds, adding to the downward pressure. Changes in confidence can therefore move the financial account and the exchange rate much faster than trade volumes move.

When a deficit becomes persistent

A persistent current account deficit is a negative current account balance that lasts for several periods, rather than resulting from a short-lived cyclical or exceptional event. How significant it is depends on its size relative to national income, its causes and the way it is financed.

A deficit doesn’t automatically signal failure. For example, stable long-term investment may finance imports of capital equipment and increase future productive capacity. Problems are more likely when a large deficit pays for consumption, relies on volatile short-term funds or causes liabilities to grow faster than the country’s ability to service them.

Exchange rates and interest rates

Continued net payments for imports can put downward pressure on the exchange rate. Depreciation may improve competitiveness over time, but imported inputs become more expensive in domestic terms, potentially creating cost-push inflation. Any foreign-currency debt also becomes more burdensome when measured in domestic currency.

Authorities may respond by raising interest rates to attract financial inflows and support the currency. That can help finance the deficit. However, the resulting increase in borrowing costs reduces consumption and investment. The trade-off is unpleasant: foreign investors may feel reassured just as domestic demand weakens.

Foreign ownership, debt and credit ratings

When inward foreign direct investment finances a deficit, it can increase the foreign ownership of domestic assets. Non-residents gain legal claims over domestic firms, land or productive capital. The investment may provide finance and technology, as well as employment. However, future profits may flow abroad, while foreign owners may control strategic decisions.

Borrowing to finance the deficit causes external debt to accumulate. External debt is a stock of financial obligations owed by domestic residents or institutions to foreign creditors. Future payments of interest and principal lead to income outflows, making it harder to improve the current account.

A credit rating is an assessment issued by a specialist agency of a borrower’s capacity and willingness to meet its debt obligations. If external debt rises while reserve coverage remains weak, the sovereign rating may fall. Lenders will then demand a higher interest rate as compensation for the additional risk, pushing debt-servicing costs even higher.

Demand management and economic growth

Demand management is the use of fiscal or monetary policy to influence aggregate demand. A government might cut domestic spending to reduce imports, but this contractionary policy can slow real output growth and increase cyclical unemployment.

Economic growth is an increase in an economy’s real output over time. Persistent deficits may weaken growth when high interest rates and falling confidence reduce investment, or when debt servicing becomes heavy. Yet a deficit that finances productive investment may support future growth. What the spending finances matters more than the negative balance by itself.

Different countries show why. Australia ran current account deficits for many years while attracting long-term investment into productive sectors, and substantial growth occurred alongside those deficits. Economies such as Turkey, by contrast, have gone through periods when dependence on short-term external finance contributed to pressure on the currency, higher interest rates and sudden falls in domestic demand. The same headline balance can hide very different risks.

Expenditure-switching policies

An expenditure-switching policy redirects spending away from imports and toward domestically produced products. The aim is to cut import expenditure and, where possible, raise export revenue without necessarily lowering total expenditure.

There are two principal methods:

• Trade protection, such as tariffs, quotas or administrative restrictions, makes imported products more expensive or harder to obtain.
• Currency devaluation in a fixed or managed system, or depreciation in a floating system, lowers the foreign-currency price of exports while raising the domestic-currency price of imports.

Both policies may increase net exports and aggregate demand. There are drawbacks, though. Protection can provoke retaliation, while a weaker currency can cause imported inflation and increase the burden of foreign-currency debt.

Expenditure-reducing policies

An expenditure-reducing policy is a contractionary demand-side policy that reduces total spending in the economy, including expenditure on imports.

Under contractionary fiscal policy, the government may raise taxes or cut government expenditure. This lowers disposable income and aggregate demand, so imports fall. Contractionary monetary policy may involve higher interest rates, which discourage consumption and investment. Higher rates may also attract financial inflows and support the currency.

This approach is most plausible when excessive domestic demand and inflation are contributing to the deficit. Its main cost is lower output and employment, particularly if the economy is already weak.

Supply-side policies

A supply-side policy is a government measure designed to increase productive capacity, efficiency or flexibility. Investment in infrastructure, education, training, research and competition can reduce production costs, improve quality and strengthen non-price competitiveness.

As domestic firms become more competitive, they may export more and replace some imports. Unlike a simple fall in demand, successful supply-side reform can improve the current account while raising long-run growth. Timing is the problem: these policies are expensive and uncertain, and they usually take years to affect trade performance.

Evaluating expenditure switching

A weaker currency works best when demand for exports and imports is sufficiently price elastic. Firms must also be able to increase export supply, while domestic substitutes for imports need to be available. The policy is less effective if imports are necessities, export capacity is limited or contracts fix quantities in the short run. Imported inflation can reduce some of the improvement because it raises costs for domestic firms.

Protection may cut selected imports quickly, but it leaves consumers with higher prices and less choice. Firms sheltered from foreign competition may also become less efficient. Trading partners could retaliate against exports, offsetting an improvement in one part of the current account with a deterioration elsewhere.

Evaluating expenditure reduction

Contractionary fiscal and monetary policy usually reduces imports when import demand is strongly linked to income. It may also lower inflation and restore price competitiveness. However, the deficit falls partly because households and firms spend less. As a result, real output and employment may decline.

Whether this works depends on what caused the deficit. Expenditure reduction may be suitable when excessive demand during a boom is the problem. If weak productivity or poor product quality is responsible, cutting demand deals with the symptom rather than the cause.

Evaluating supply-side measures

Supply-side policies tackle structural competitiveness. They can increase exports without depressing domestic demand, and may lead to productivity growth, lower cost-push inflation and greater export diversification.

Results take time and remain uncertain. These policies also involve opportunity costs and the risk of government failure. Better ports won’t guarantee export success when global demand is weak. Likewise, improved training offers no immediate help if firms lack finance or market access.

Ireland’s long-term investment in education and infrastructure helped support high-value exports, showing what supply-side measures can achieve. However, multinational-company transactions also affect its current account data. The composition of the figures therefore matters, rather than just the quoted balance.

Iceland’s external adjustment after the 2008 crisis raises a different problem of interpretation. A much weaker currency encouraged exports and tourism, while the recession sharply reduced imports. Both expenditure switching and expenditure reduction improved the current account, so crediting one policy alone would be misleading.

A conditional judgement

No single method is always the most effective. The source of the deficit should guide the policy mix:

• excessive aggregate demand may justify expenditure reduction;
• an overvalued currency may justify exchange-rate adjustment;
• weak productivity requires supply-side reform;
• excessive dependence on a narrow range of imports or exports calls for structural diversification.

Any judgement should also account for growth, employment, inflation, income distribution, debt and relations with trading partners. Correcting the current account through a deep recession may improve one statistic while reducing overall economic welfare.

Price elasticity and the current account

Depreciation or devaluation makes exports cheaper in foreign currency and imports more expensive in domestic currency. This creates both price effects and quantity effects.

For exports, the lower foreign price initially cuts revenue per unit, though quantity demanded may rise. For imports, the higher domestic price increases expenditure per unit, while quantity demanded may fall. The strength of these quantity responses determines whether the current account improves.

The Marshall-Lerner condition states that depreciation or devaluation will improve the current account, once quantities have adjusted, if the sum of the absolute price elasticities of demand for exports and imports exceeds one:

where $PED_x$ is the price elasticity of demand for exports (dimensionless) and $PED_m$ is the price elasticity of demand for imports (dimensionless).

When the sum exceeds one, the combined quantity responses are large enough to outweigh the adverse unit-price effects. If the sum is below one, the current account may deteriorate.

The J-curve

The J-curve effect describes a time pattern in which depreciation or devaluation initially worsens the current account before improving it later.

In the short run, demand is usually relatively price inelastic. Orders were agreed in advance, consumers need time to find substitutes, and firms need time to change production and distribution. Import prices rise immediately but import quantities change little. Export volumes may respond slowly as well, so the current account moves further into deficit.

Over time, buyers switch products, exporters expand output and the elasticities increase. If the Marshall-Lerner condition is eventually satisfied, export revenue rises relative to import expenditure and the current account recovers. The resulting path resembles the letter J.

The diagram must start from the balance immediately before the currency change. It should show an initial deterioration below that level, followed by recovery. Crossing the zero-balance line shows a move from deficit into surplus. Simply rising above the original balance shows improvement, even if the account remains in deficit.

Domestic consumption and investment

A persistent current account surplus is a positive current account balance that continues over several periods. It may signal strong export competitiveness. However, it can also result from restrained domestic consumption or weak domestic investment.

When households consume relatively little, the economy imports fewer goods and services, leaving more domestic output available for export. In the short run, living standards might be higher if households consumed more. On the other hand, high saving may finance future income.

A current account surplus is normally matched by a financial account deficit, so domestic residents are often acquiring assets abroad. Those assets can diversify wealth and generate future income. But this pattern may suggest that savings are going overseas because domestic investment opportunities are limited. That isn't necessarily harmful; the outcome depends on the quality and return of investments at home and abroad.

Exchange rates and export competitiveness

Export receipts create demand for the domestic currency, so a surplus can cause appreciation. This lowers import prices but increases the foreign-currency price of exports. As a result, export competitiveness may fall. This is the ability of domestic firms to sell successfully against foreign producers on price and non-price grounds.

Over time, this exchange-rate response may reduce the surplus. The effect is weaker if the exchange rate is managed or if the country shares a currency with other economies. Germany, for example, cannot experience a separate appreciation of a national currency within the euro area. The normal adjustment mechanism is therefore constrained.

Inflation

The effect on inflation is ambiguous. Strong net exports raise aggregate demand and may cause demand-pull inflation when the economy is near capacity. Yet any resulting appreciation makes imported consumer goods and inputs cheaper, reducing imported cost-push inflation. If weak domestic demand causes the surplus, it may also be associated with low inflation.

Employment

Strong exports support jobs in exporting and import-competing industries. Workers and firms in these sectors benefit from external demand. Later, however, appreciation may weaken export orders. An economy that suppresses domestic spending to preserve a surplus may also create fewer jobs in domestically oriented industries.

Interpreting country patterns

A surplus needs to be examined over several years and relative to the economy’s size. Germany’s surplus has often been linked to competitive manufacturing and relatively restrained domestic demand. Norway’s surplus, by contrast, has been strongly influenced by energy exports, with part of the proceeds invested abroad through public saving. The causes differ, so the implications differ too.

Patterns shift with the economic cycle, commodity prices, exchange rates and one-off income flows. Rather than asking only whether the balance is positive, consider why it is positive, whether it is persistent and which groups gain or lose from maintaining it.